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Yielding to Stocks

For income, some equities look better than Treasuries

By JAY PALMER

When a ship is sinking, it's time to start thinking -- of life vests and life boats. With the stock market in seeming freefall, investors have been running for the safest of safest investments, U.S. Treasury notes. But they also present risks. The income is fixed -- and these days that income stinks. The yield on the 10-year Treasury notes last week fell to a paltry 4%, the lowest in 40 years. That income adds up to little, if anything, after taxes and inflation are taken into account.

Ironically, this rush to safety has made bonds riskier. "Our fear is that investors continue to pour into the 10-year Treasury market in an attempt find risk-free returns as risk aversion has climbed to possibly unsustainable near-term highs in reaction to severe stock market losses over the past two-and-a-half years," writes Salomon Smith Barney strategist Tobias M. Levkovich. "The key problem is that such herd-like moves generally have met with investment disaster." If the yield on 10-year Treasuries were to revert to 5.30-5.40%, where it was last spring, the price of the notes would fall 30%. "With stocks down 40% in the last two-and-a-half years, and bonds up something like 60%, we would argue that stocks seem to be the safer investment alternative now," Levkovich concludes.

Moreover, you can get higher income from some stocks now, including those of some of the largest and most financially secure companies, which hold out the prospect for earnings growth as well.

With all this in mind, Barron's ran a screen to identify alternatives to bonds for income investing, setting the parameters with the help of Marc Gerstein, Multex's Director of Investment Research and author of the just-published book, "Screening the Market."

On his advice, we started by knocking out REITs, limited partnerships and gas and electric utilities, which are special cases. We then scanned for stocks yielding 4% or better, eliminating those that had cut their payout in the past five years. We also specified investment-grade debt ratings (a Standard & Poor's rating of triple-B-minus or better.)

Finally we looked at corporate earnings. While Street analysts have been wildly overoptimistic, projections tend now to be more conservative. We looked beyond the current year's turmoil, including only stocks where analysts expect earnings to rise by at least 5% in their next fiscal year.

These parameters turned up a total of 20 companies, listed in the accompanying table. Some of the biggest and best-known names in the market meet the criteria, including members of Dow Jones Industrials such as Philip Morris, J.P. Morgan Chase, Eastman Kodak, General Motors and SBC Communications. Others making the cut include Bristol-Myers Squibb, which is still dealing with a hangover following the admission it inflated 2001 revenues by $1 billion, and Verizon Communications, another Baby Bell. Other high yielders include GATX, a finance and railroad-car leasing company; Lyondell Chemical, a specialty chemical company and chewing-tobacco maker UST.

But a screen like this is only a starting point, and investors should be prepared to delve into the specifics of individual picks in much greater detail. Even a cursory look at the list reveals that several companies have problems.

A case in point is PerkinElmer, a maker of scientific instruments used in the telecom, medical, pharmaceutical, chemical, semiconductor and photographic markets. The company makes the screen principally because of the way the yield has risen as the stock price has dropped from a 52-week high of 36 to about 6, reflecting both stockholder lawsuits alleging corporate misstatements and insider selling, as well as a recent downgrading of the firm's debt ratings.

Aon, an insurance and consulting firm, faces similar lawsuits, and its earnings are marred by special charges and sharply declining margins not cured by reorganization efforts. So grim are market conditions that the firm cancelled the planned spinoff of its underwriting business. Cooper Industries, a maker of electrical products and tools, recently reported higher second-quarter earnings, but warned that markets remain weak and that full-year profits will be well below previous expectations. Further, the company is on several investment blacklists for relocating its headquarters to Bermuda for tax reasons.

Banks feature prominently in the screen, with J.P. Morgan Chase, FleetBoston, PNC Financial, National City and KeyCorp all making the cut. "These are all large-cap banks but, aside from that, they don't have much in common," observes Steve Gresdo, managing director of BankStocks.com. "National City is as clean as a whistle, having avoided most of the problems affecting the industry. So too is KeyCorp, though it's downsizing and more defined by the turnaround going on. PNC has a lot of capital-markets and asset-management exposure, but the really vulnerable banks are J.P. Morgan and Fleet. Both have been under severe pressure due to exposure to large corporate lending, Latin America and the weak merger-and-acquisition field."

Tobacco, hardly a hot sector during the bull market but a strong one since the market's 2000 peak, is also featured: giant Philip Morris and UST. The latter, which is off 20% from its high reached in early May -- in part owing to a major antitrust lawsuit -- is on several top Wall Street buy lists. Earnings have risen and are projected to keep doing so. There also is the supposition that the company faces a relatively benign smoking litigation threat. And a planned $500 million stock buyback has won favor among investors.

In addition, two of the largest Baby Bells make the screen -- Verizon and SBC -- both after sharp slides in their stock prices. Initially, at the height of the WorldCom furor, the regional Bell operating companies were viewed as a communications safe haven. But that view has been taking a hit, partly following a stream of sour tones on the earnings from the sector but also after the disclosure that the fourth and smallest RBOC, Qwest Communications, will restate earnings due to overly aggressive accounting strategies. Finally, there is mounting concern over falling wired-line counts as cellular and cable modems supplant second phone lines in many homes. But as Barron's pointed out recently ("Pay Me Now," July 15), the Baby Bells have the wherewithal to boost their payouts.

The changing relationship between stock and bond yields is not unprecedented. From after the 1929 crash until the early 'Fifties, equities yielded more than bonds because they were deemed to be riskier. After the crossover, stocks were bought for capital gains and bonds for income.

In recent years, there has been a reversal; the 10-year Treasury has returned 11% this year while the Standard & Poor's 500 has lost 20%. And as investors increasingly look to dividends, that role reversal may continue.

Should Payouts Be Tax-Free Zones?

The idea gains some notable backing

By SHIRLEY A. LAZO

Is it an idea whose time has finally come? Can Congress help the stock market by eliminating the corporate dividend tax -- or the double taxation of dividends?

In his Aug. 12 Investment Strategy Weekly, Edward E. Yardeni, chief investment strategist at Prudential Securities, shares his views on what can be done to boost stock prices and revive the confidence and wealth of individual investors.

Yardeni proposes that shareholders receive their cash-dividend payments tax-free, an idea recently advocated by such notables as Alan Greenspan, Henry Kaufman and George W. Bush, who indicated approval of it at the president's economic forum in Waco, Texas, last week. As Yardeni puts it, "shareholders should be encouraged to act as owners of the corporations in which they invest. Managers should be encouraged to treat them as owners, too. It is the owners of the corporation who pay taxes on profits. Why should they be taxed again on their dividend income? This double taxation creates a tremendous incentive for management to retain rather than distribute earnings."

The current system, says Yardeni, "gives too much power to management and tends to effectively disenfranchise the shareholder…. Without the discipline of dividend payments, management has a great incentive to use every trick in the rule book and every conceivable accounting gimmick to boost earnings. Investors are forced to value stocks on easily manipulated and inflated earnings rather than on the cold hard cash of dividends."

Yardeni believes that if dividends were exempt from the personal income tax, investors would tend to favor companies that pay dividends and have established a record of steadily enhancing their payouts. "Shareholders could then decide for themselves whether to reinvest their dividend income in the corporation based on the ability of management to grow dividend payments rather than earnings." Obviously, dividends would grow at the same rate as earnings, assuming a fixed payout ratio. But Yardeni asserts that "dividends would discipline the accounting for earnings. Management can't pay cash to shareholders unless the cash actually was earned."

One objection to axing the tax is that such a radical change would raise the cost of capital to growth companies that pay no dividends and retain all earnings. "With the benefit of hindsight," notes Yardeni, "we can safely say that there was a huge misallocation of financial, capital and human resources to those growth companies at the expense of the rest of the economy during the previous decade….Fast-growing companies with fast-growing earnings should have no problem paying fast-growing dividends. Their outstanding performance would be rewarded with a fast-rising stock price and a low cost of capital."

Another objection to not taxing dividend income is that it amounts to an unfair windfall for the rich at the expense of widening the federal budget deficit.

Actually, Yardeni points out, "the experience of the late 1990s demonstrated that a rising stock market can narrow the federal budget deficit and even change it into a surplus. Eliminating taxes on dividends is likely to revive the stock market as a wealth-creating engine of growth."......

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Compare to Cramer's comments on investing in stocks that pay good dividends on RealMoneyTalk from 8/14, 15, 16 here...

http://www.thestreet.com/radio/#archives

OK - maybe Cramer read Yardeni's Aug. 12 Investment Strategy Weekly prior to his 8/14 RealMoneyTalk radio show....Jen

-- posted by Jen_